THE MACROECONOMIC BENEFITS OF GOOD CORPORATE GOVERNANCE

James Gordon

Senior Resident Representative

IMF New Delhi

January 16, 2002

Introduction

1. In recent years, the IMF has begun to pay increased attention to the issue of corporate

governance. In no small part, this new emphasis has arisen from the realization that poor

corporate governance was an important element in the East Asian financial crisis of the late

1990s. Of course, a good system of corporate governance has long being recognized as

important for the domestic economy, in that it can raise efficiency and growth, and

particularly so when securities markets play a primary role in financing investment. The

recently-observed link with external financial stability thus provides an additional reason

why corporate governance is of macroeconomic significance.

2. Corporate governance issues have thus become part of the IMF’s surveillance

activities, and have also featured prominently in IMF-supported programs (the recent Korean

program being a prime example). Consistent with its mandate to promote macroeconomic

stability and non inflationary growth, the IMF limits its concern with corporate governance to

those issues with a clear macroeconomic impact. The more micro aspects of corporate

governance fall within the expertise of other multilateral institutions, such as the World Bank

and the OECD.

3. My talk today is divided into three parts. First, I will discuss the links between

corporate governance and the macro-economy. Second, I will describe current efforts by
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multilateral institutions to improve corporate governance--as part of the so-called Standards

and Codes initiative. Finally, I will conclude by drawing some implications for India.

Macroeconomic Effects

Growth effects

4. In a liberalized financial market, savers can choose between alternative investment

opportunities. In such an environment, more open and transparent companies with good

business prospects are likely to be better able to finance new investments. This will be

particularly true if these companies have access to equity or bond markets, since such direct

financing does not require collateral, and will also tend to be of longer maturity than bank

lending. In addition, the cost of capital for such firms should be lower, since the better is

corporate governance, the better investors are able to price risk.

5. The macroeconomic benefits are obvious. Growth is likely to be highest when capital

is allocated to those that use it best. A strong system of corporate governance equips savers

with the information and confidence necessary for them to lend funds directly to companies.

This applies equally to foreigners, who will become more willing to provide their savings to

the country, and, in particular, to the corporate sector. Investment should increase, thereby

boosting productivity and growth across the economy. In these different ways, good

corporate governance can lead to higher economic growth, although to reap the maximum

benefits, it is also necessary that the financial system is sound.1

1
While there is some evidence linking corporate governance to corporate efficiency—see Meesook et al, 2001-
-this does not preclude high growth being achieved via alternative financing methods in which corporate
governance is less important (such as the bank-financing model employed by the Asian tigers). However, recent
events raise doubts about the sustainability of high growth achieved by these means.
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Stability effects

6. In addition to the growth effects, strong corporate governance can reduce the

likelihood of a domestic financial crisis, in which investors lose confidence in the assets

which they own. In India, the Government moved quickly a year ago to strengthen the

institutional structure of the Indian stock exchanges when just such a crisis threatened. As

noted, poor corporate governance has also been associated with external crises, and it is this

aspect of macroeconomic stability that is a primary concern of the IMF.

7. Corporate governance was an important element in the crisis that befell Korea in

1997.2 In the period before the crisis, the Korean chaebol (conglomerates) had created a

complex web of cross-guarantees and cross-equity holdings that allowed weaker affiliates

easy access to credit markets, and reduced accountability for bad investment decisions.

Cross-shareholdings allowed a dominant family to control a company, sometimes with little

of its own capital at risk. In addition, assessment of the chaebols’ health was made difficult

by the absence of consolidated financial statements.

8. As long as Korea grew rapidly, foreign investors did not seem overly-perturbed by

this lack of transparency. However, once confidence in the Korean miracle began to sour in

1997, the chaebol came under close scrutiny, and the speed with which investors exited

Korea is well-documented. However, in light of the subsequent robust recovery, there was

clearly an element of over-reaction in their behavior. Some of this could have been avoided if

more information about the corporate sector had been available. An effective system of

2
See Chopra, et al, 2001.
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corporate governance would also have blocked the chaebols’ more-questionable

investments, thereby reducing the chances of a crisis emerging in the first place.

9. In the case of Korea, poor corporate governance undoubtedly aggravated the crisis,

and the concerted attempts that were then made to improve corporate governance were an

important ingredient in the subsequent strong recovery. On a broader canvas, recent research

has found a relationship between the state of corporate governance in an economy and the

severity of the crises that it suffers.3 Nonetheless, this link should not be over-emphasized.

Some countries with good corporate governance have had crises. Other countries with poor

corporate governance have avoided them. In fact, the evidence indicates that corporate

governance is only one of a number of factors that influence the probability of a crisis.

However, the lesson from Korea is that strong corporate governance can be a useful attribute

when a country with an open capital account is under scrutiny from nervous foreign

investors. There are clear implications for India, to which I will return.

Standards and Codes

10. The frequent crises of the 1990s have led to various initiatives to strengthen the

international financial system. These have included proposals to reform the IMF; to involve

the private sector in crisis resolution, and most recently, to introduce a system of sovereign

debt restructuring. Moreover, the financial contagion that occurred between emerging

markets during the 1990s has highlighted the need to better inform market participants about

the economies in which they are investing, as well as the need to strengthen financial

infrastructures in the economies themselves.

3
See Johnson, et al, 2000.
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11. To achieve these objectives, the international community has used international best

practices to develop a system of Standards and Codes. These cover a wide range of areas,

including macroeconomic policy, and financial regulation and supervision, as well as

“infrastructure” issues, such as bankruptcy practices, and corporate governance. (There is a

full list of the different Standards and Codes on the IMF’s web site, www.imf.org.) Since

some of these standards may be too demanding for developing countries to comply with

immediately, it is recognized that implementation will be gradual (and on a voluntary basis).

Nevertheless, as countries implement the Standards and Codes, the risk of disruptive shifts in

market sentiment should diminish, and financial systems should prove more resilient to

events in other parts of the globe.

Implications for India

12. In 2000, in conjunction with the World Bank, India participated in the preparation of

a Report on the Observance of Standards and Codes (ROSC) regarding its corporate

governance. This report shows that in a number of areas, current practices fall short of the

OECD standards. The scope to improve corporate governance in India will be much

discussed in this conference over the next few days. I will leave this discussion to those more

expert on this subject than myself, but would note that from a macroeconomic perspective,

improved corporate governance can deliver a number of benefits:

• A better allocation of capital over time, and hence higher productivity and growth.

• Increased ability of Indian companies to raise funds overseas and compete

internationally; and

• Stronger foundations for further opening of the capital account.

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13. This last point is particularly significant in light of the recently-published Approach

Paper to the 10th Five Year Plan. This document envisages that larger current account deficits

will be required in India over the period of the plan if high growth is to be achieved. The

better is India’s corporate governance, the more likely these larger current account deficits

can be financed with longer-term and less speculative funds, including foreign direct

investment (FDI). Good corporate governance can thus reduce the chances of an external

crisis in the future, even as capital inflows increase and remaining capital account restrictions

are phased out.

14. In his recent excellent survey of the state of corporate governance in India, Omkar

Goswami argues that being a transparent and well-governed company makes good business

sense. I hope that I have convinced you this morning that having a transparent and well-

governed corporate sector also makes good macroeconomic sense.

Thank you.

REFERENCES

Chopra, A., Kang, K., Karasulu, M., Liang, H., Ma, H., and Richards, A., From Crisis to Recovery in Korea:
Strategy, Achievements, and Lessons, October 2001, IMF WP/01/154.

Goswami, O., The Tide Rises, Gradually: Corporate Governance in India (CII/OECD), April 2001.

Johnson, S., Boone, P., Breach, A, and Friedman, E., Corporate governance in the Asian Financial Crisis,
2000, Journal of Financial Economics, 58, 141-186.

Larsen, F. (2001), The Challenges of the New Financial Economy: the Efforts of the IMF to Reduce the Risk of
Financial Crises, Paris, November 2001,www.imf.org.

Meesook, K., Lee I-H., Liu O., Khatri, Y., Tamirisa, N., Moore, M. and Krysl, M. (2001), Malaysia: From
Crisis to Recovery, IMF Occasional Paper 207.